Thursday, May 21, 2009

Too Big Has Failed

I've been wrestling with writing a blog post on how I think we should fix the financial mess. Happily, it turns out that Thomas Hoenig has written it for me. Whew!

Mr. Hoenig points out a basic problem we have now:

If an institution's management has failed the test of the marketplace, these managers should be replaced. They should not be given public funds and then micro-managed, as we are now doing under TARP, with a set of political strings attached.

He reviews past financial crises and the mechanisms used to successfully deal with them:

financial crises continue to occur for the same reasons as always -- over-optimism, excessive debt and leverage ratios, and misguided incentives and perspectives -- and our solutions must continue to address these basic problems.

Then he points out flaws in the existing TARP mechanisms, that can be fixed by using the procedures that were used before. That is, establish a simple metric for declaring a financial institution insolvent, fire the management of insolvent institutions, bring in new management, allocate losses to shareholders first, and then to unsecured lienholders, and take out all or a portion of the bad assets for seperate disposal. This isn't new thinking; Mr. Hoenig is just saying we should do it now even though the failing institutions include the largest US banks (you know who you are, Citibank!)

Finally, he looks forward to avoiding our current problems in the future:

One other point in resolving "too big to fail" institutions is that public authorities should take care not to worsten our exposure to such institutions going forward. In fact, for failed institutions that have proved too big or too complex to manage well, steps must be taken to break up their operations and sell them off in more manageable pieces. We must also look for other ways to limit the creation and growth of firms that might be considered "too big to fail".

The underlying problem is that when a single entity or network grows to become vital to taxpayer interests, that entity achieves a claim on taxpayer resources. Firms should have to pay for such a claim. Many will find it cheaper to break themselves up. Identification of networks vital to taxpayer interests is an extension of existing antitrust laws.

Mr. Hoenig is the president of the Federal Reserve Bank of Kansas City.

One problem any kind of government takeover and cleanup of a failing bank incurs is that the new entity is unnaturally "clean" compared to the non-failing banks with which it competes. Folks like Warren Buffet complain that they are penalized for having played well.

First, the complaint isn't entirely true. As long as the shareholders of the failed institutions get wiped out, the shareholders of non-failing institutions do better in comparison, and so to the extent that shareholders guide bank operations in the future, they will tend to guide away from failure.

The complaint is true, however, for the individuals at the failing banks. Folks working at Citibank and AIG have made more money than folks working at less spectacular non-failing banks, and they've kept their undeserved gains. I think we need a better system for aligning the interests of bank shareholders and those who work at banks. It's not enough to give the folks working at the banks options or shares, because shareholders do not have enough power right now.